Lessons from the rise and (possible) fall of Chinese township-village enterprises.

• Jurisdiction: United States
• Date: 01 February 2004
• Author: McDonnell, Brett H.
• Published date: 01 February 2004
• Author: McDonnell, Brett H.

TABLE OF CONTENTS INTRODUCTION I. BACKGROUND SKETCH II. PUZZLE 1: THE GROWTH OF TVEs IN THE 1980s III. CONTRACTUAL AND PROPERTY RIGHTS REFORM IN TVEs IV. PUZZLE 2: RELATIVE STAGNATION OF TVEs IN THE 1990s V. FUTURE PATHS AND POLICY CHOICES A. The Path of Liberalization and Privatization B. The Path of Democratization C. The Path of Aborted Reform VI. PROPERTY RIGHTS AND ECONOMIC DEVELOPMENT--FOUR LESSONS A. Lesson One: Property Rights Are Neither Necessary nor Sufficient for Development B. Lesson Two: Political Constraints Matter C. Lesson Three: Property Rights Are both the Effect and Cause of Development D. Lesson Four: The Path of Reform May Affect What Is Reachable in the End INTRODUCTION

China has been one of the great successes in the developing world over the last two decades. A crucial part of the growth of industry in China has been the rapid growth of township-village enterprises (TVEs). The success of TVEs poses a puzzle for a property rights approach to the theory of the firm, since no one really holds well-defined, transferable property rights to control and claim the residual profits of TVEs. TVEs also pose a second puzzle: in the last five or seven years, they have started to experience serious problems, despite reforms which have improved TVEs from a property rights perspective. This Article will take ideas from property rights and institutional approaches to economics and examine whether those ideas can help explain both of these puzzles. In turn, it will ask what light that examination throws upon property rights and institutional approaches, particularly as applied to developing and transitional economies.

China has the world's largest population and one of its largest economies. Many project that within several decades China will surpass the United States and become the world's largest economy. (1) It is both the world's largest developing nation and also the largest nation making the transition from a communist economy. These facts alone would make Chinese economic institutions a matter of great interest for anyone who cares about the relationship between property rights and economic development. China holds even greater interest for such people because it has followed such an unusual path in making its transition. Rather than using a "big bang" strategy and trying to liberalize, privatize, and quickly move to a capitalist market economy, China has taken a much more gradual approach, leaving many of its older institutions at least somewhat in place while introducing new ones and making piecemeal reforms in the old ones. At least as compared with Russia, this gradualist approach seems to have worked well so far.

TVEs have been an important part of this approach. Part I sketches the background facts concerning TVEs and their role within the Chinese reforms. It explains where townships and villages fit within the political structure of China and how the success of TVEs emerged as a largely unintended by-product of deregulation of product markets combined with incentives created by the government's federal structure. The Part presents some figures on the rapid growth of TVEs and the recent slowdown in that growth. It also briefly explains the complex stew of competing types of enterprises in China.

Part II takes up the first puzzle which this Article addresses, namely how TVEs managed to flourish despite being defined by quite ambiguous property rights. TVEs are, in theory, owned by and held for the residents of the township or village in which they are located, meaning that, in effect, local government and party officials have final control rights over them. Managers run their daily affairs. One must thus consider the incentives facing both these managers and the government and party officials. It appears that the partial reforms of the 1980s gave both officials and managers enough of a stake in the success of TVEs that they had decently strong incentives to promote their growth.

Their incentives were better than those facing decision makers in the two main rival types of enterprises: state-owned enterprises (SOEs) and private enterprises. SOEs, which are typically large businesses owned and run by higher levels of government, are controlled by a variety of government agencies, none of which have adequately strong stakes in making the SOEs more efficient. Moreover, SOEs face a serious soft budget constraint as state-run banks guided by agencies provide loans to failing businesses to keep them afloat. Vis-a-vis private enterprises, TVEs had the key advantage that they were better protected from government regulation and predation. The combination of federalism and product market competition in China's political structure was critical in creating the relative advantages of TVEs.

Part II also considers two conflicting accounts of the success of TVEs in the first stages of reform. One account treats TVEs as only a transitional institution whose advantages over private enterprise arise only because the State could not or would not commit to nonintervention in the affairs of private enterprises. Once a rule of law is in place to protect private enterprises, under this account, TVEs will disappear. A differing account suggests that, perhaps for cultural reasons, TVEs are an innovative organizational form which offers lasting advantages. Later Parts return to this question.

Despite the impressive achievements of TVEs in the 1980s and early 1990s, they were very far from perfect institutions, in part for reasons suggested by property rights theory. Neither government/ party officials nor managers had clear rights either to residual returns or to residual control. Part Ill reports on a variety of experiments that were tried to improve on the situation. Several different types of contracts with enterprise managers were tried to improve their incentives. Ownership reforms also were instituted to loosen and regularize the control of government and party officials. Part Ill reports on evidence from other researchers which suggests that those reforms did improve productivity, as property rights theory would suggest.

Part IV turns to our second puzzle, namely the more recent problems facing TVEs. Why, given the reforms described in Part III, have TVEs not done better recently? One key part of the answer seems to be that competing organizational types, especially private enterprises and enterprises with foreign direct investment, have become more attractive. Indeed, many TVEs have been privatized. Part IV considers why that might be so, and also discusses the barriers that remain for private enterprises in China. It also suggests that TVE privatization need not necessarily represent an improvement in efficiency--rent seeking may also explain some of what is going on. The other key part of the answer to the puzzle of the decline of TVEs may be the serious limitations which they face. In particular, TVEs may lack the organizational incentive structure needed to work well as they grow due to their initial success. Cultural norms and personal ties which keep small-scale TVEs working may not be adequate to the task of supporting larger businesses. These points should not yet be pushed too far, though. TVEs currently face serious problems, but they are still an important part of the Chinese economy, and their possible decline into minor status is far from a done deal.

Part V considers various paths which Chinese reform may follow in the future. One path stresses further liberalization and privatization, with the goal of reaching a Western-style market economy dominated by private enterprises. Movement along this path will require a variety of major reforms: banks and capital markets must be freed from state dominance, the property rights of private businesses must be secured, courts must become more independent, and labor markets must be reformed, to name some of the biggest and most obvious tasks, This path, in turn, splits into two branches: one branch leads to a U.S.-style system dominated by capital markets; the other branch leads to a Japanese- or German-style system dominated by banks.

The second path strives to create a more unique Chinese system, building on the strengths of TVEs. Chinese culture and society might allow TVEs to become strong community-based, cooperative businesses that integrate various stakeholders' interests well. This path requires reforms to enhance democracy and accountability within both local governments and TVEs themselves. This path leads to a destination more unknown, and hence riskier, than the first path, but it cannot be said with any certainty that the path is necessarily inferior to the first. It is probably less likely to be taken than the first path, however.

Looming as the major overarching obstacle on both paths is the tradition, and still reality, of Communist Party dominance over all areas of life in China. The great achievement of the reforms to date is giving Party members a stake in enhancing the efficiency of TVEs and private enterprises and to provide some degree of commitment against pervasive Party influence in the economy. However, the reforms have gone only so far in achieving those ends--much more needs to be done. The great question facing China is whether Party members will be willing to undertake additional reforms which further limit the Party's influence. The hope is that past reforms have set in motion a political and economic dynamic which give enough Party members a strong stake in further reform. The fear is that those with ultimate power will still feel too threatened if reform, at some point, calls into question the ultimate authority of the Party. Thus, another possible path is that the reform process will break down while the Chinese economy still has a long way to go in catching up with Western nations. This is the least desirable of the paths and probably less likely to be taken than the first path (leading to Western-style...